Friday, 20 December 2013 00:00

The Perils of Chasing High Yield

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This month, we take a break from our discussion of more general financial topics to cover a more “technical” investment strategy currently in favor among some money managers and DIY investors: chasing high yield. Simply put, this strategy involves targeting specific asset types such as preferred stocks, “high-yield” bonds, real estate investment trusts (REITs) and other vehicles that offer rates of return that are often much higher than those being delivered by the market in general. You might reasonably ask, based on that definition, why pursuing higher returns for your portfolio could be described as “perilous.” After all, isn’t growth the goal? Our answer, with a caveat, is: yes, strong returns are a good thing, but chasing high yield is often little more than a gamble that the market is wrong. High-yield products exist, frankly, because no one would ever buy them without the lure of the returns they promise to compensate for higher risk of default.

As we’ve mentioned in past articles, helping our clients benchmark their tolerance for healthy risk is one of the cornerstones of our investment methodology. High-yield investment products are inherently high risk. Take preferred stocks, for example. The promise of receiving regular dividend payouts before common stock holders is very attractive to most investors. However, the high-yield trend toward “hybrid preferred” stock carries with it the very real risk that your holdings could be automatically converted to common stock, meaning both a reduction of income AND capital! Careful attention to technical nuances like yield-to-call date is especially important when investing in preferred stocks. If you have the time and the energy to spend in this sort of analysis, preferred stocks may work for you. Otherwise, you’re gambling on a high cash yield that may or may not ever materialize.

High-yield bonds also provide a cautionary tale. As with preferred stock, there is often a reason that the returns on high-yield bonds are so tantalizingly attractive, and that reason is usually linked to the bond’s rating. Issuers often have to offer high returns because the bonds are poorly rated or offer significant risk of default! Without the lure of a high interest rate, very few investors would put their money into these types of bonds. As the old saying goes, “You can put lipstick on a pig…but it’s still a pig.” In our experience, high-yield bonds wear a LOT of lipstick.

Wanting average or above-average returns is fundamental to investing. No one wants to lose money, after all. But chasing high yield is not for the faint of heart, and is often little more than an “educated bet” on market performance. Building a solid investment strategy that focuses heavily on managing risk, allocating assets prudently, and being patient may not have the flash and glitz of chasing high yield, but it will assuredly pay off better than gambling on a sucker’s bet. In this rising interest rate environment, lower your yield to maturity and be patient.

 

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